A private foundation set up by an individual provides the opportunity to shift income to an entity that will be taxed at a minimal rate, achieve tax savings, and direct charitable giving, yet the individual maintains control over the assets used to fulfill charitable purposes. For some individuals, maintaining control over assets set aside for charitable commitments is important, while others would prefer to make an outright gift. If an individual has strong charitable convictions, a planned gift-giving program could include setting up a private foundation.
Private foundations are an excellent way to involve family in long-range charitable giving, investing and controlling funds available for charitable distribution, and meeting charitable commitments regardless of personal financial fluctuations. However, because of the restrictions on activities of a private foundation, the costs associated with operating one, and the limitations imposed on the deductibility of contributions, the practitioner should carefully analyze a taxpayer’s goals to determine if a private foundation is appropriate.
Requirements and Characteristics of a Private Foundation
A private foundation is any organization described in Sec. 501(c)(3), other than a public charity, a publicly supported organization, or a supporting organization. The most common type is a nonoperating foundation. In simplest form, a nonoperating foundation is a separate legal entity that holds funds as an endowment and uses the income to support other charitable activities and organizations. By contrast, an operating foundation (for example, a museum) uses its funds for its own operation, including the purchase and maintenance of assets.
The foundation’s assets can be used for religious, charitable, literary, scientific, and educational purposes, preventing cruelty to children or animals, or fostering amateur sports competition (other than providing athletic facilities or equipment) (Secs. 170(c)(2)(B) and 4942(g)(1)). A private foundation can also contribute to government entities described in Sec. 170(c)(1) (Regs. Sec. 53.4942(a)-3(a)(2)).
The benefits of establishing and funding a private foundation include the following:
Control: Once donors make gifts to public charities, they typically have no control over how their donations are used. However, with a private foundation, the donor is often also a foundation manager and so is able to control how the foundation invests its assets and ultimately disburses them for charitable purposes.
Legacy: Donors often name their foundations after themselves or their families. Although a large gift to a public charity can provide lasting name recognition to the donor (such as when a university names a building after a substantial donor), it is often easier (and perhaps less expensive) to perpetuate the family name using a foundation.
Family ties: Donors often view a foundation as a way to bind a family together with a common interest. Often, a private foundation’s board includes several members from a donor’s family, such as the spouse, children, or grandchildren. Many donors also see the foundation as a way to pass on to younger family members their ideas about philanthropy.
Narrowly defined causes: Donors can use a private foundation to advance or support charitable causes that public charities in their area do not serve or are not interested in.
Long-term charitable giving goals: A private foundation may provide the opportunity to meet long-term charitable giving goals by using the essentially tax-free buildup of assets.
Current tax deductions for funding: The income, gift, or estate tax charitable contribution deduction is available upon funding the foundation, even though the foundation may not make the charitable distribution until some time in the future.
Relief from solicitation requests: A private foundation can be used to relieve the donor from the burden of having to personally respond when solicited for charitable contributions. Instead, the donor can refer requests to the foundation.
Disadvantages of a Private Foundation
However, there are some disadvantages to be aware of when determining whether a private foundation is appropriate:
Foundations are costly: The donor will incur costs to organize and operate a private foundation. Usually, professional fees are incurred to draft the organizational document, ensure that all state filing requirements are met, file the application for exemption from federal income tax (Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code), maintain accounting records, and annually file Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation. There may also be state reporting requirements.
Income tax deduction is more limited: Individuals may deduct cash gifts to public charities up to 50% of their AGI and property gifts up to 30% of AGI (unless the donor elects to deduct the cost basis rather than the FMV of the property) (Secs. 170(b)(1)(A) and (C)(iii)). With a private nonoperating foundation, however, the deduction for cash gifts is generally limited to 30% of AGI, and property gifts are normally deductible only up to 20% of AGI (Secs. 170(b)(1)(B) and (D)).
Penalty (excise) taxes can be levied: Most private foundations must pay an annual excise tax of 2% of their net investment income. (Some foundations qualify for a 1% rate—see Sec. 4940(e).) In addition, private foundations (and in some cases their managers or boards) are potentially subject to excise taxes because of self-dealing, a failure to distribute income, excess business holdings, political expenditures, or inappropriate expenditures or investments (see Secs. 4941–4945 and 4955). These excise tax rules are complex and potentially very costly.
Public inspection: A private foundation’s annual tax returns (Form 990-PF) and supporting documents, including names and addresses of contributors, must be available for public inspection. This can be an issue for donors concerned about their privacy.
Administrative complexity: Many individuals do not fully comprehend the administrative time required to compile the information needed to comply with the various rules for reporting foundation activities. Likewise, individuals may not fully understand the complexity of the restrictions placed upon disqualified persons.
Identifying Clients That May Benefit from a Private Foundation
Generally, an individual must have fairly high wealth and a desire to make substantial charitable contributions to derive benefits that exceed the cost of establishing a private foundation.
Often, a private foundation is established when the donor’s taxable income is unusually high. The donor shelters that income from tax with funds that are not actually disbursed to charity for some time. In addition, an individual may want to secure a charitable contribution deduction in a high-income year but cannot decide on the charitable recipient. A private foundation can be formed and funded (generating a current charitable contribution deduction), although distribution to the ultimate recipient is deferred.
Establishing a private foundation may be appropriate for an individual who has made charitable commitments for an extended period. The individual can fund the foundation currently, take a charitable contribution deduction in a high-income year, and make future charitable gifts from the foundation. This strategy works well if the donor funds the foundation while he or she is in a higher tax bracket than the years the charitable donations are actually made (e.g., a retiring executive). Not only does the donor secure a current tax deduction, he or she also obtains nearly tax-free asset growth to fulfill future charitable commitments.
An individual planning to bequeath a large amount to charity may prefer leaving the assets to a private foundation rather than gifting them outright to a public charity. During his or her lifetime, the donor establishes the foundation, defines the charitable purposes in the foundation’s organizational documents, and can also appoint the foundation officers. Establishing a private foundation gives some assurance that the funds will be distributed, over time, to charitable causes that the donor wishes to support.
An individual with an interest in a cause not well supported by public charities can form a private foundation. For example, the foundation could grant scholarships to a certain class of individuals (e.g., children living in an orphanage) or provide research grants for a specific topic.
Finally, some wealthy donors use private foundations to bind the family together by supporting a common interest. The foundation’s board may contain several family members who share a sense of working together for a common goal. The foundation can also employ members of the donor’s family. However, the salary should be reasonable based on the duties performed to avoid any risk of being an act of self-dealing.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 12th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.